Our subordinated debt pool is evaporating

The fixed-interest option of subordinated corporate debt is rapidly drying up for Australian retail investors.

Summary: Australian could soon have only $2.3bn of corporate subordinated debt left, comprising just four issues.

Key take-out: With corporate debt off the table, fears of unexpected risk in bank hybrid notes is further frustrating investors.

Key beneficiaries: General investors. Category: Fixed interest.

Leaving aside the recently launched Qube subordinated debt issue, the range of ASX-listed debt securities available to retail investors is in danger of becoming extremely limited.

In fact, before long, retail investors may find their choice limited to Additional Tier 1 capital issued by banks and just a smattering of senior ranking debt and perpetual notes.

Many of the other subordinated notes listed on the ASX are set to disappear over the next 12 months or so.

Woolworths will redeem $700 million of subordinated notes in November without replacing them, and Origin Energy will redeem its $900m issue in December. Origin has said nothing about replacing the notes.

March will see Tabcorp’s $250m issue reach its call date, and Caltex’s $550m issue is due to be called in September, along with Goodman Group’s $327m issue in December. Goodman Group is a repeat issuer, but the other two are not.

If none of the issues are replaced there will be only $2.3 billion of corporate subordinated debt left, comprising just four issues with call dates ranging from March 2018 to July 2021.

The outlook is even more dire for subordinated debt issued by financial institutions. No issuance has been seen from these issuers since 2013.

Financial institutions now only issue Additional Tier 1 capital to retail investors, with subordinated debt issues directed to the wholesale market. It also remains to be seen whether Additional Tier 1 capital issuance will go the same way.

In the meantime Commonwealth Bank subsidiary, Colonial Holding Company, has $1bn of notes due to be called in March, NAB has $1.17bn falling due in June, along with a $1.509m issue from ANZ. And $1.168bn of subordinated notes are due to be called by Westpac in August.

After this, there will be just three issues remaining with a face value of $2bn. All are scheduled to be called in 2018.

By way of comparison, there is more than $31bn of Additional Tier 1 capital listed on the ASX and more to come from ANZ’s Capital Notes 4 issue.

Putting shareholders ahead of hybrid noteholders

From January 1 this year new rules came into effect limiting the distributions that banks can make should their Common Equity Tier 1 capital ratio fall below buffer requirements.

This has been the subject of recent commentary in financial media, expressing concern that holders of bank hybrid notes could face an unexpected risk of receiving only partial distribution payments when a bank is not in financial difficulty in the usual sense of the term.

If a bank is in danger of breaching the minimum 5.125 per cent Common Equity Trigger, or indeed is at the point of non-viability as determined by APRA, distributions will not be paid and conversion of the hybrid notes into ordinary equity is likely. But now if a major bank’s Common Equity Tier 1 capital ratio should fall below 8 per cent, the Australian Prudential Regulation Authority may require that only a partial distribution be paid on hybrid notes when due.

Under APRA’s prudential standard, APS110, the major banks must have a minimum of Common Equity Tier 1 capital ratio of 4.5 per cent of risk weighted assets. To this is added a 2.5 per cent capital conservation buffer and a D-SIB (domestic systemically important banks) imposition of 1 per cent.

There is also a counter-cyclical buffer that can be applied, but this is currently set at zero. Thus a major bank must have a minimum ratio of 8 per cent of Common Equity Tier 1 capital to risk weighted assets. Should the ratio fall below this level, distributions to shareholders, Additional Tier 1 capital (hybrid) noteholders, and staff bonuses will be restricted.

Earlier this month, APRA released a clarification paper to APS110 to address concerns that have been raised that timing differences in the payments of dividends and hybrid distributions may result in a dividend being paid in full and a subsequent hybrid distribution being restricted.

A perception that shareholders were being favoured over hybrid noteholders would severely damage investor confidence in hybrid notes.

Clearly such an outcome would not be in a bank’s interest but serves to illustrate the shortcomings of hybrid notes as a form of capital relative to real equity (shareholders’ funds).

APRA’s considered response to the concern raised can be paraphrased as thus: “Tough!”

APRA expects banks to manage their distributions to shareholders, hybrid noteholders and staff in such a way that this outcome is avoided.

Philip Bayley is an independent consultant to debt capital market participants and is associated with Australia Ratings.

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